Hyperliquid's Journey (Part 4): Reckoning

Make a wish every day for the arrival of a @YBSBarker technical partner.

What followed the war was not peace, but a long reckoning.

October 11th was a comprehensive disaster, possessing all the elements of previous cryptocurrency crashes: FTX's liquidity depletion, the policy critique of the September 4th incident, UST's stablecoin depegging, and the March 12th "plug-in" deleveraging. The main storyline remains the same: Binance and Hyperliquid are facing off for the third time. Following $JELLYJELLY and Aster, Binance remains unable to halt Hyperliquid's continued growth, even though Hyperliquid's ADL triggered earlier and the apparent liquidation scale is larger. This isn't surprising; Hyperliquid's MM alliance strategy is still working. This is bizarre, as Hyperliquid's HLP is vying for profits.

In extreme times, ADL removes HLP's appendix

Trump made his declaration at 8 pm, and the market maker fell critically ill an hour later.

Entangled in a web of internal and external, on-chain and off-chain funds, USDe became the Achilles' heel of market makers' liquidity migration, ultimately breaking through Binance's perpetual contract price maintenance system and, under normal operation of Ethena's minting/redemption system, piercing the weak liquidity on Perp DEX. Binance's price feed mechanism failed on USDe, and it didn't adopt Aave's hard-coded 1:1 USDT peg, demonstrating extreme confidence in its own liquidity. Unfortunately, this confidence was provided by external market makers. Perp is still essentially a leveraged lending product. Failure to timely human intervention can lead on-chain protocols to more proactively consider potential crises. For example, the on-chain liquidations during the DeFi Summer period gave rise to the duopoly of MakerDAO and Aave amidst the massive volatility.

Picture description: DeFi Summer liquidation

Picture source: @KaihuaQIN

It’s just that Perp’s performance is more intense, and exchanges/Perp DEX will actively increase leverage or change margin mortgage rates in order to compete. The ambiguity of the full-position/separate-position mode allows some copycats to obtain the mortgage ability of BTC and USDT. According to a Binance customer service representative, altcoins themselves have no value, and near-infinite leverage will eat up all profits. Even if all the taxes collected in Goose City were paid back decades later, it wouldn't be enough to pay them back. Bad debts are incurred by exchanges, typically funded by fees and ultimately by counterparties. Exchanges can even earn a reputation for smoothing over crises. Unlike second- and third-tier CEXs that covertly or overtly support their own market makers, Binance has largely avoided such accusations. From the previous Web3Port price manipulation to the FUD-fueled Wintermute and DWF on October 11, none of them can be considered part of the Binance ecosystem. Binance itself is the largest source of liquidity in the cryptocurrency market. Binance's profit-maximizing strategy is to attract the most projects and retail investors. Market makers then automatically maintain liquidity, allowing Binance to earn fees, projects to exit, market makers to profit from the spread, and retail investors to contribute profits to everyone. Second- and third-tier exchanges or the numerous Perp DEXs cannot replicate Binance. Small exchanges can profit directly from retail investors by engaging directly in market making, eliminating the intermediary processes of attracting investors (projects) and attracting investors (market makers). Perp DEXs utilize the LP token method pioneered by GMX to stimulate liquidity. Ultimately, the strong will always be strong, and Hyperliquid is taking a middle path. HLP attracts retail investor retention, while the market maker alliance maintains post-issuance liquidity, achieving the best of both worlds. Binance's liquidation volume is a black box, ranging from billions to $300 billion to $400 billion. CZ then turned to prediction markets and settled the matter with $283 million in compensation to retail investors. Consider Bybit's post-hack operations. Exchanges are profit-driven from the start. Regardless of the facts, retail investors will eventually forget. The real danger lies with Hyperliquid. After the October 11th liquidation, cracks in Hyperliquid's alliance approach were revealed. HLP, in conjunction with ADL (Auto-Deleveraging), liquidated $7 billion, earning HLP a $40 million profit.

ADL is called a nuclear weapon,, that is, the longs pay off the shorts' debts, and the shorts abandon the longs' debts, so the exchange will do its utmost to avoid this from happening. Once it is not handled carefully, it will be like BitMEX in 2020, doing its utmost to avoid the occurrence of ADL, saving the currency circle and sacrificing itself (which was regarded by the outside world as "pulling the plug", and Binance took the opportunity to rise).

The usual order of handling emergency events:

• Exchange: crisis occurs–> market-based liquidation–> insurance fund takes over positions–> ADL forces counterparties to close positions

• Perp DEX: crisis occurs–> market-based liquidation–> LP Vault takes over positions–> ADL forces counterparties to close positions

In theory, in order to maintain trading order, ADL will be triggered only after the insurance fund is unable to maintain or is exhausted, or in order not to trigger ADL, the bad debt maker will close its position in advance, the price of Perp products will extend to -♾️, and the crisis will naturally end if it is closed before the margin is exhausted. However, HLP handles both market making and liquidation, fundamentally different from the insurance funds of Binance and BitMEX. Market making strives to maintain price stability, but liquidation can create crises and even exploit the tension created by this contradiction. In the $JELLYJELLY incident, large investors accumulated positions exceeding $4 million in a market with a market capitalization of $9 million. The market was unable to maintain counterparty and liquidity, so HLP was forced to passively take over the positions, ultimately leaving all HLP holders with a $12 million loss. Neither bad debts nor profits disappear; they are merely transferred. The $40 million profit comes at the cost of a previous $12 million loss, which is relatively safe for a $500 million trading volume. The real danger is that HLP's dual role will divide the interests of users, depositors, and market makers. 1. Large investors, or professional traders, need to take advantage of Hyperliquid's no-KYC and liquidity to trade or deploy strategies, and they want Hyperliquid to remain absolutely neutral. 2. Depositors want HLP to earn more, meaning they want to maintain a higher market-making share and participate in more "profitable" liquidations. 3. Market makers want HLP to engage in more liquidations and less market making, limiting their involvement in currencies they can make markets in, so they can exit the market when liquidity is insufficient. The Hyperliquid team strives to maintain a balance among the three. Jeff stated that HLP's market-making share has dropped from 2% in March to 1% in October. Beyond PR, HLP's market-making volume will decline, but it won't reach zero. External market makers are not entirely reliable. From a development perspective, Hyperliquid needs to shed HLP before it can flip to Binance, T0. Otherwise, it will remain an on-chain version of T1 CEX. Realistically, Hyperliquid cannot abandon HLP. All profits come from retail investors' losses, and retail investors will invest in HLP.

Image Caption: Trading Volume and Profit

Image Source: Three images stitched together, the original author can't be found

From the above data, Hyperliquid is the undisputed number one on Perp DEX. Even after experiencing the largest drawdown, it remains the absolute OI king. The flywheel of dominance has been established, while HL Killer products such as Lighter still need more practice.

Everyone can discuss the right and wrong of Hyperliquid's premature launch of ADL in the controversy, but they will directly mock LLP's failure in its first stress test. You can be bad, but you can't be bad. In the extreme PVP market, Hyperliquid has at least won for now. There are indeed whales who can profitably exit, and there are indeed HLP users who can receive commissions. This is enough to sustain the market until the time comes for it to be unwound. However, what will happen in the future? HLP needs to find a balance between traders and market makers. Who is the lender of last resort? Liquidation is a gradual dam collapse process, and liquidity is the strongest gravity dam. Liquidation may appear to be a failure of market making, but in reality it is a result of drastic price fluctuations. Due to stampedes and runs, all liquidity will eventually flee. The ballast that was supposed to smooth price fluctuations has now become a huge wave that makes prices even more unstable. As mentioned earlier, Perp is nothing more than another form of leveraged lending, but the lending product is over-collateralized, and the liquidation mechanism has evolved from crude auction bidding and discounts to the integration of DEX and lending. When the over-collateralization ratio drops, it is gradually sold on DEX, turning discrete downward sell-offs into a continuous and smooth recovery.

Image description: Price changes under different selling mechanisms

Image source: @zuoyeweb3

The integration of AMM DEX and lending is more friendly to liquidation, but the liquidity of Perp DEX cannot get rid of its dependence on the vault mechanism. Hyperliquid can't do it, so don't make it difficult for HL Killers. A quick complaint: anything called "XX Killer" ultimately fails to achieve anything significant. Consider Ethereum's Avalanche Killer, Solana, and Binance's FTX Killer. Perp DEX's extreme liquidation problem (daily liquidations can be resolved through market-based processes) directly restricting price declines will inevitably undermine market efficiency. Establishing an insurance fund, ADL, margin trading funds, or circuit breakers can only mitigate the problem, but they won't convince everyone through product design. There can't be a power vacuum. Binance's large liquidation volume is due to its large market size. HL's liquidation volume is also larger than Lighter's. HLP sacrifices the interests of traders. In the long run, to make the protocol more neutral, the market-making/liquidation roles must be productized; otherwise, the protocol will inevitably serve as the ultimate liquidator. Who acts as the lender of last resort in the crypto market? Assets like BTC, super market makers, or exchanges? • Perp DEX Protocol: Current trading volume cannot sustain itself. Even Hyperliquid has yet to escape Binance’s pull. • BTC: Assuming the asset will slowly recover its market value, it may take years. The half-life of a 4-year cycle is also around 2 years. Refer to the FTX debacle. • MM: It’s good enough if you don’t lose everything. There’s no way to force action. The fate of Wintermute / GSR / Flow Traders / DWF is uncertain. • CEX: Without external supervision, it is almost impossible to establish or operate. No one really believes that Binance is in the same boat with the interests of retail investors, right? By the way, Binance still far surpasses Hyperliquid. The large liquidation volume this time is also due to scale. From the perspective of system robustness, HL > BN > Lighter, and from the perspective of market stability, BN > HL > others. If Hyperliquid's trading volume expands 10-fold to Binance's scale, Binance's current problems will also become Hyperliquid's future problems. After all, what industrially developed countries show to less developed countries is only the latter's future. Regarding liquidation, HLP is the appendix of Perp DEX, continuing the GMX model and imitating the AMM DEX LP. In addition to providing liquidity, it also adds clearing functions. However, the interests of HLP and Hyperliquid cannot be completely separated. Even if ADL liquidation does not "protect" HLP positions, there is no guarantee that this will always be the case. Market rumors circulate that Ethena and CEXs have formed an alliance of interests, which will benefit them from the ADL system. This is because CEXs are major investors in Ethena. If they can protect Ethena, they can also protect themselves, market makers, and large investors, resulting in a world where only retail investors suffer. From the perspective of both assets and price discovery mechanisms, the former views ADL as a fat-tail event. Due to the volatility and lack of regulation of cryptocurrencies, black swan events occur far more frequently than in traditional financial markets, and recovery mechanisms rely primarily on self-healing.

Here is an ADL option product concept that I envisioned. Based on Hyperliquid's open, transparent and automated ADL data, you can design a binary option or prediction market product, encouraging everyone to invest part of their transaction fees when opening an order, or HLP, into it, which will be used as liquidity to predict the probability of triggering ADL. Regarding liquidity, since ADLs don't occur frequently (although the probability is relatively high, the probability of a daily, weekly, or monthly occurrence is still low), they can be designed to expire monthly, thereby attracting market makers or retail investors who are betting against them, or even directly utilizing the HIP-3 mechanism. Since CEXes like Binance don't report transparent liquidation data, most unrealized profits cannot be redeemed. Therefore, ADL options aren't intended to provide insurance coverage and are unable to fully compensate ADL victims. However, as long as the losses exceed Binance's compensation, there is a market for them. To ensure the safety of HLP, the Hyperliquid team is motivated to trigger ADLs as early as possible. Hedging with options is the best approach, with spot contracts hedging, contract options hedging, and an endless loop of options. The other is a price discovery mechanism, a technological innovation. Variational utilizes RFQ matching, an OLP unified market-making mechanism, and a P2P liquidation strategy. • RFQ: Users request prices from market makers, becoming the primary market player. • OLP: Variational centrally manages the market-making mechanism. All users trade with OLP, and users depositing OLP earn a return. • P2P: After a user places an order, OLP searches for matching orders and fully balances them. Even if bad debts arise, they won't affect others. However, this isn't a Variational ad, so we need to objectively consider the issues with these mechanisms, primarily liquidity. Yes, everything is about liquidity. Variational is essentially a clearing protocol that's a hybrid of on-chain and off-chain, CEX/DEX. When you bet against OLP, OLP itself lacks liquidity, and may even place orders on Hyperliquid or Binance. Essentially, users are still trading with market makers on Binance. The significance of Variational's approach is that it offers discounts to large customers. Furthermore, OLP is the sole market maker. While the protocol states it won't engage in malicious market making, such a black-box market-making strategy is unlikely to be fully accepted by the market. Even the fully transparent Hyperliquid (on-chain) primarily conducts its governance within Discord. Asset X price corresponds to collateral X leverage. Infinitely extending leverage ultimately devalues ​​the collateral. Conclusion: Hearing thunder in the silence reveals the constant shifting of market microstructures. March 12, 2020: BitMEX's "network unplugging" saved the crypto market, sacrificing BitMEX's market share and allowing Binance to rise. November 8, 2022: FTX's insolvency ultimately failed to save itself, sacrificing SBF and the entire industry, leading to crypto's stagnation. October 11, 2025: Binance's partial transparency and public relations efforts saved it, while Hyperliquid used ADL to forcibly liquidate profitable positions, leaving the outcome uncertain. Regardless, liquidation has become the most difficult issue for Perp products to resolve. As Hyperliquid grows, it may only take one more liquidation for it to be brought under regulation. Hopefully, before that happens, the crypto space can develop its own lender of last resort, demonstrating its superiority over Wall Street.